Why Gold and Silver Are Soaring

Gold and silver have had phenomenal weeks, with the metals rising nearly 3 percent and 6 percent, respectively. Many columnists are claiming that this is due to escalating tensions in Iraq and the rising possibility that the Iraqi state will enter a state of chaos.

But this really isn’t the case, or it is in the same way that the assassination of the Archduke Ferdinand “caused” World War 1: It was the trigger, but in itself it was not the driving force behind the war. So perhaps there are some speculators that bought gold this week because they are concerned that political tensions in Iraq will escalate, but there are deeper factors driving the price that have been driving the price higher for many years now. Only those investors who understand this will have the confidence to buy gold when the market is weak, or when geopolitical tensions in Iraq (or anywhere for that matter) dissipate.

The price of gold has been rising for several fundamental reasons. The first is that demand is rising faster than supply. This demand is coming primarily from Asia, as central banks and citizens from that region of the world have more resources with which to buy gold, and they have a desire to do so. Prior to the beginning of the bull market—which began at the beginning of the century—people in Asia were far poorer than they are today. Furthermore, central banks and Asian governments didn’t have the massive influx of foreign reserves resulting from trade surpluses that they have today. Asian nations were debtor nations, and their productive capacities were limited with a couple of exceptions (e.g. Japan).

But now this has changed. Asians at the individual and at the government and central bank levels have wealth, and they are inclined to put this wealth into gold. Unlike Americans Asians aren’t drawn to the stock market. That isn’t to say they don’t have “animal spirits” or the desire to gamble (e.g. consider Macau). It’s just that stock ownership isn’t a concept that has been sold to Asians the way it has been sold to Americans: They don’t have easy access to wealth managers and online trading services.

They also don’t have the faith in the U.S. Dollar that Americans have. Asians recognize that the Dollar is a fiat currency and that it only has value insofar as others are willing to accept its value. The same can be said about Treasuries, which are nothing more than future claims on Dollars. Gold and silver, on the other hand, require an enormous amount of effort to produce, and this gives them intrinsic value. Investors in Asia recognize this, and this is why we saw Asian investors flock to gold last year when the price was falling—they saw a bargain and wanted to take advantage.

The second reason is that the value of the Dollar is declining. The Federal Reserve has been increasing the money supply at an incredible rate over the past several years. Its balance sheet is about $4 trillion whereas just before the financial crisis it was less than $1 trillion. Even with “tapering,” the monetary base is still increasing at a rate of about 10 percent this year. While a lot of this money supply growth is exiting the country, thanks to America’s negative trade balance as foreigners become more reluctant to accept Dollars and dollar-denominated assets this extra money will come back to the U.S. and bid prices higher.

Investors tend to ignore this explanation and argue that gold didn’t rise when quantitative easing started, and so therefore an increase in the money supply doesn’t impact the gold market. But the lack of an immediate market reaction doesn’t invalidate the argument. The gold market will react to the increase in the money supply at some point even if it isn’t an immediate effect. Remember that markets aren’t that easy to navigate, and market etiology isn’t always immediately apparent, yet assuming that it is and making investment decisions based upon this assumption is extremely dangerous, and it is probably one of the most costly investment mistakes that people make.

The two reasons for gold’s rise have held true for a long time now, and they have held true when the market was both rising and falling. The takeaway is that investors need to stop looking at near-term singular events as valid explanations of price action and they need to take a longer-term view. While doing so may be frustrating when the market moves against you, you will be rewarded for your patience and reasoning.